Wealth Preservation
Winter 2009

Roth Conversions in 2010 and Beyond

The rules have changed for 2010 and thereafter, as there is no income restriction on converting a Traditional IRA to a Roth IRA. Currently, you can’t make the conversion at all if your household has more than $100,000 in Modified Adjusted Gross Income. As a special rule for 2010 only, the option is to report the amount of income from the Roth conversion evenly in 2011 and 2012 or all in 2010.

This is not a recommendation to convert your Traditional IRA to a Roth IRA, but to consider whether converting some of your IRA would result in more wealth for your family. There are many moving parts to the equation and there is no one size fits all as everyone’s situation is different.

*There could be a penalty of 10% if client is not over 59 ½ or the account is not open for 5 years and earnings after conversion are withdrawn. Earnings do not come out until after all converted (taxed) funds are withdrawn.

Here is the hurdle. To convert, you must pay income tax on the amount converted. If you have to pay taxes at a higher rate to convert than you would pay on your normal distributions, conversion would not in most cases result in more wealth. Future tax rates are the primary component in the equation. Further, to pay the taxes necessary to convert, using funds outside of the IRA are necessary to make conversion viable. The taxes you pay now, take away from fund’s ability to grow, which is part of the equation.

Also, in most cases, anyone who needs their required minimum distribution or more to live on would not be a likely candidate. Conversely, a person who does not need their IRA to live on could be a possible candidate for conversion. As stated above, there are no Required Minimum Distributions (RMD) for a Roth IRA. The application of RMDs forces money out of the tax favored environment and into a regular taxable account and grows less tax efficiently due to ongoing taxation. The money paid in taxes is no longer available to grow. This is still driven by tax rates and the longer the period of time that the IRA remains whole the greater impact on future wealth.

The Roth offers an opportunity to pass a valuable legacy to your heirs. Beneficiaries, other than your spouse, are required to start taking distributions from a Roth one year after inheriting the Roth. The required withdrawals are based on the beneficiary’s life expectancy and the money comes out tax free. This allows for potentially many more years of tax free compounding.

Another piece of the equation involves estate taxes. The impact can be a little or a lot depending on the make of your estate. It may be as little as the impact of state estate taxes, but if your IRA is a large part of your estate, there could be some savings at the federal level.

The person doing your taxes knows your tax situation and would be the one to crunch the numbers to see if a conversion makes sense. You will still need to make assumptions as to the future of tax rates as they apply to you. The ability to convert continues beyond 2010 giving the opportunity to do small amounts each year to keep your marginal tax rate lower. With the unpredictability of the future of tax rates, tax diversification could be the key. That way you will have made the right decision on either the portion you converted or the portion not converted.

A Roth conversion transaction can be reversed under the recharacterization rules. The recharacterization rules allow you to transfer any assets that were converted to a Roth back to an IRA again. This must occur by the tax return due date including extensions.

As previously stated, this is not a recommendation to convert but to explore the possibility that converting some of your Traditional IRA to a Roth may provide more wealth for your family.